Differentiate the internal rate of return and time-weighted return when applied to alternatives
The idea
Time-weighted return measures the performance of a strategy independently of when money entered or left, which is why it is the standard for evaluating a manager of a fund the investor can enter and exit freely. Private funds are different: the general partner controls the timing of drawdowns and distributions, so that timing is part of what is being judged. The money-weighted internal rate of return is therefore the appropriate measure there. Comparing a private fund's IRR with a public index's time-weighted return is not a like-for-like comparison.
A practice question
Why is the internal rate of return used to evaluate private equity funds?
- Because it is easier to compute than time-weighted returnWhy not: It is harder, requiring a solution rather than a chain of period returns.
- Because the manager controls the cash flow timing — correct
- Because IRR is always higherWhy not: It is not always higher, and choosing a measure for flattery would be the wrong reason in any case.
That timing is part of the performance being judged. When the manager decides when capital is called and returned, excluding timing from the measure would exclude a large part of what the manager does.
A harder one
When is time-weighted return the more appropriate measure?
- When the investor controls timing — correct
- When the fund uses leverageWhy not: Leverage affects the return's size and risk rather than which timing convention suits.
- When returns are negativeWhy not: Sign has no bearing on which measure fits; the question is who controlled the timing.
Contributions and withdrawals chosen by the investor are not the manager's decisions. Holding a manager responsible for flows they did not choose misattributes the result, and time-weighting strips out that effect.
The hardest tier
Why is a private fund's IRR not directly comparable with a public index's annual return?
- Because private funds report net of fees and indexes do notWhy not: A real difference and a correctable one, unlike the structural difference between the two measures.
- Because IRR is expressed in a different currencyWhy not: Both are expressed as rates, and currency is a separate matter entirely.
- Because the two measure different things — correct
IRR assumes a capital base that changes over time and reflects timing the manager controls, while an index return assumes a fixed amount invested throughout. Public market equivalent methods exist precisely to force the comparison onto common ground by running the private fund's cash flows through the index.
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